Nondeductible IRA -- bad idea?

[slowsaver]

I have read that contributing to a nondeductible ira is a bad deal because you are just locking-up money with no tax advantage.

Some people still contribute to one, just to roll it over to a roth ira. However, I do not want to roll this money to a roth.

Instead, I was wondering whether there might be some advantage to save highly taxable funds, like bond funds or reit funds in a non-deductible IRA to avoid getting 1099's from these investments during my high tax-bracket years (now). My 401k is already maxed-out.

Thanks for your thoughts.

 

[audreyh1]

You do have a tax advantage - all the distributions paid out over the years compound tax free. You don't pay any tax on them until you withdraw from the account.

 

[youbet]

Actually there is a tax advantage, especially if you're young and have decades for the earnings to compound tax free. Money you would have given to Uncle many years ago is still there in your account working for you.

I funded nondeductible IRA's for many years and have no regrets. Today, retired, I fund my son's non-deductible IRA every year. At withdrawal time, the earnings are taxable but your basis (the after tax dollars you funded the IRA with) come out tax free.

An added benefit is that if you change your mind about Roth conversions later, the money is there to convert.

 

[LOL!]

Just remember that gains in your non-deductible IRA will probably eventually be taxed at your marginal income tax rate, plus it will have RMDs, plus your heirs will not get a tax break on this either.

OTOH, gains in a taxable account will be taxed at the lower long-term capital gains tax rate which could be 0%, there will be no RMDs, and if you die, your heirs get a stepped up basis.

Fill your 401(k) with things like REITs and bond funds that pay dividends. Fill your taxable account with tax-efficient equity funds that you can occasionally tax-loss harvest and that pay either no dividends, low dividends, or qualified dividends. And if they pay foreign taxes, get the foreign tax credit, too.

Also note that a non-deductible IRA will also interfere with a future Roth conversion. I do have to wonder why you would not want to roll this money into a Roth IRA as soon as you could. Can you tell me your thoughts on that?

 

[youbet]

Just remember that gains in your non-deductible IRA will probably eventually be taxed at your marginal income tax rate.

That may be a good thing. Years and years of ordinary interest and short term cap gains compounding on a tax delayed basis while you're in the 33% marginal bracket followed by withdrawals while retired in the 15% or 25% bracket are a good thing. I like to delay tax on earnings and eventually pay the taxes at a lower rate. I agree that a LTCG in a TIRA leads to higher taxes if withdrawn while you're in a higher than 15% bracket. But I focus on short term trading and ordinary interest in the TIRA and leave the long term equity holding to the non-deferred accounts.

In the case of funding a non-deductible IRA for my adult son, I have POA and really enjoy short term trading the account. Because it's an IRA, my playing doesn't cause him any headaches at income tax prep time. With the exception of a few rare times I caught a div from a stock I was trading (usually unintended) gains are STCG. They stay in the account, tax delayed, for me to continue to play with. When DS withdraws the money 2 - 3 decades from now, he'll pay the tax at his then marginal tax rate. He and his DW are currently in a high tax bracket. If he wants, he can do some Roth conversions later in life, including after he's fired and has no earned income. It seems like a good way to go.

Also note that a non-deductible IRA will also interfere with a future Roth conversion.

Interfere? How is that? I'm doing Roth conversions from a TIRA that has mixed deductible and non-deductible funding with zero problems? Am I missing something?

 

[slowsaver]

Also note that a non-deductible IRA will also interfere with a future Roth conversion. I do have to wonder why you would not want to roll this money into a Roth IRA as soon as you could. Can you tell me your thoughts on that?

My income is too high to contribute directly to a Roth, and I unfortunately rolled an old 401k with $100k from a previous employer into an IRA. From what I read, this makes it pretty much impossible to back-door my nondeductible IRA money into a Roth without paying serious taxes.

 

[Fermion]

I do have to wonder why you would not want to roll this money into a Roth IRA as soon as you could. Can you tell me your thoughts on that?

+1

Unless you already have another traditional IRA that is preventing you from doing a tax free conversion into a Roth, why would you not immediately convert your non-deductible IRA into a Roth after you make a contribution. Do you just like paying taxes in the future instead of no taxes at all?

 

[Fermion]

My income is too high to contribute directly to a Roth, and I unfortunately rolled an old 401k with $100k from a previous employer into an IRA. From what I read, this makes it pretty much impossible to back-door my nondeductible IRA money into a Roth without paying serious taxes.

Oh, in that case, you should try to roll it back into a 401K by mowing grass or something. This will hide the money and let you continue to do backdoor Roths.

 

[slowsaver]

Actually there is a tax advantage, especially if you're young and have decades for the earnings to compound tax free. Money you would have given to Uncle many years ago is still there in your account working for you.

I funded nondeductible IRA's for many years and have no regrets. Today, retired, I fund my son's non-deductible IRA every year. At withdrawal time, the earnings are taxable but your basis (the after tax dollars you funded the IRA with) come out tax free.

This was the advice I was hoping to hear -- thanks!

 

[steelyman]

This was the advice I was hoping to hear -- thanks!

Guys like Cramer remind me of Yosemite Sam.

You will be fine.

 

[slowsaver]

I funded nondeductible IRA's for many years and have no regrets. Today, retired, I fund my son's non-deductible IRA every year. At withdrawal time, the earnings are taxable but your basis (the after tax dollars you funded the IRA with) come out tax free.

I'm curious how this works: Let's say I put money into this non-deductible IRA every year for the next 25 years, then take-out a little bit of money when I'm 65 years old (in 26 years). Do you get to tell the government that you only took-out basis money and not earnings money, or is it calculated some other way? Does this become an accounting nightmare when you start to withdrawal money?

 

[tmm99]

Oh, in that case, you should try to roll it back into a 401K by mowing grass or something. This will hide the money and let you continue to do backdoor Roths.

That's exactly what I would do too. Reverse roll over the IRA back into the current 401K and then convert the non-deductible IRA to Roth.

 

[Animorph]

Here's Morningstar's take (or at least Christine Benz's):

Morningstar Free Smartpage | News

"The trouble is, the nondeductible Traditional IRA has never been a particularly useful vehicle, even for high-income savers. Instead, its main utility is as a conduit, for those who can't make a direct Roth contribution and intend to convert their Traditional IRAs to Roth. If such a conversion doesn't make sense, investors are almost always better off skipping the IRA wrapper altogether and investing in a taxable account instead. It's not difficult to achieve nearly tax-free compounding within a taxable account--provided you take care with investment selection--and you'll be able to obtain better tax treatment on your withdrawals, to boot."

I stayed in my taxable account instead of using a nondeductible IRA. It funds early retirement pre-59.5 and Roth conversions while we're low income otherwise. We'll be withdrawing from the tIRA throughout retirement most likely, so we didn't need any more in there.

 

[GrayHare]

I prefer the advantages of a growth stock over a non-deductible tIRA: 1) no need to wait for retirement: you can withdraw (sell shares) whenever you want without penalty or limitations, 2) if the stock pays no dividend, you pay no tax until you choose to sell shares, 3) when you sell shares the gains are taxed at the Capital Gains rate, which historically has been lower than the tax on IRA withdrawals, and 4) unlike the IRA the stock gets a step-up in basis upon your death, reducing taxes for your heirs.

 

[youbet]

I'm curious how this works: Let's say I put money into this non-deductible IRA every year for the next 25 years, then take-out a little bit of money when I'm 65 years old (in 26 years). Do you get to tell the government that you only took-out basis money and not earnings money, or is it calculated some other way? Does this become an accounting nightmare when you start to withdrawal money?

It comes out on a pro-rata basis. If at withdrawal time, half is basis and half is earnings, then half is taxed as ordinary income. TurboTax does this for you and it's not complicated. Since every year you do a non-deductible contribution you'll fill out a 8606 - easy, quick, thank you TT, everything TurboTax needs to know to handle it painlessly is there. Mainly, the EOY value of the IRA and the basis.

You mentioned, however, that the thing keeping you from doing Roth conversions is the 100k rollover IRA. If I were you, I'd do some pencil pushing on that. If you converted that rollover IRA about $20k a year over five years, I know you'd have a painful tax hit ($6.6k/yr if you're in the 33% bracket) but after that you could do back door Roths to your heart's content.

I don't like to pay taxes early. But OTOH, I also recognize the value of tax delayed compounding of earnings, especially if you're talking about a long time like your 25 yr period.

I'm doing some Roth conversions now in the 28% bracket.

But getting back to the non-deductible TIRA, I think it worked out OK. I did most of this before back door Roths were available and I'm glad I did. The pros and cons expressed by the other posters have some valid points too.

 

[slowsaver]

I stayed in my taxable account instead of using a nondeductible IRA. It funds early retirement pre-59.5 and Roth conversions while we're low income otherwise. We'll be withdrawing from the tIRA throughout retirement most likely, so we didn't need any more in there.

Do you put bond funds and reits in your taxable accounts?

I already have tax efficient stock funds in taxable accounts, and need more bond and reit investments to maintain my chosen AA.

 

[Animorph]

Do you put bond funds and reits in your taxable accounts?

I already have tax efficient stock funds in taxable accounts, and need more bond and reit investments to maintain my chosen AA.

I'm basically all stocks. While I bias the heaviest dividend payers towards the tax advantaged accounts, I do have some in the taxable accounts. As I'm in retirement currently and Roth converting, the taxable accounts will only be around another 10 years or so I think.

I don't think bonds are terrible in taxable accounts. A Roth account with all bonds might be giving up a lot of potential growth. So I let the IRS tax my 0.90% online savings account interest and the few bonds I hold that should do a little better than that for a year or two.

 

[LOL!]

Re: bonds and REITs. If you have filled up tax-advantaged accounts and still want bonds and REITs, then use tax-exempt muni bond funds in taxable, but not REITs. If you still want REITs, move some bonds out of tax-advantaged into tax-exempt muni bond funds in taxable.

And if you still want REITs, some places have suggested a variable annuity from Vanguard because contributions would not be limited like a non-deductible IRA. But I have to say "Blech!"

 

[LOL!]

Oh, full disclosure: I have a non-deductible IRA and it has been the biggest investing mistake that I have ever made.

 

[GrayHare]

Oh, full disclosure: I have a non-deductible IRA and it has been the biggest investing mistake that I have ever made.

Same here, though Roth conversion helped correct the mistake. It was decades after I'd started a tIRA that I finally learned ALL withdrawals would be taxed as ordinary income. I had wrongly thought IRA gains were kept in separate tiers so the portions would be more favorably taxed as dividends, cap gains, etc. It was not a pleasant surprise to learn I'd wasted decades of low-tax growth I could have had via growth stocks instead of the higher-tax tIRA "trap".

 

[pb4uski]

I'm not a fan of non-deductible IRAs. I would prefer taxable myself.

 

[growing_older]

Years and years of ordinary interest and short term cap gains compounding on a tax delayed basis while you're in the 33% marginal bracket followed by withdrawals while retired in the 15% or 25% bracket are a good thing.

I like the non-deductible IRA better than taxable. I have enough taxable for years of living expenses and hopefully for plenty of Roth conversions after my taxable income goes down in ER. Meanwhile, I can let that account earn as much as it can without paying tax at my peak tax rate.

 

[audreyh1]

I don't understand people thinking it was a big investing mistake. My IRA was all in a small cap stock fund and is now like 6x the cost basis.

When I bought in I did not have a ROTH conversion option.

Also, only 10% of our retirement fund is in tax-deferred accounts. And maybe 10% of that is the non deductible IRA. Maybe that's the difference.

Yes, overall I'm glad now that most of our funds are in taxable accounts.

 

[slowsaver]

Thanks for all the comments. I think I will avoid the non deductible ira for now.

 

[meierlde]

This discussion shows that one use 401ks and irs for fixed income and taxable for equities. That is by far the most tax efficient. So a non deductable ira might be a good place to hold bond funds since you can defer the taxes (if interest rates were at a reasonable level)